Treasury Report Finds Fewer Small Businesses

By

Kristina Peterson

Updated Aug. 9, 2011 4:00 p.m. ET

Few groups are as fiercely defended by Republicans and Democrats alike as small-business owners—especially when it comes to changes in the tax code. But a new analysis from the Treasury Department suggests that the pool of actual small-business owners may be smaller than officials previously thought.

The report from Treasury's Office of Tax Analysis, to be released Tuesday, developed a new methodology to identify small businesses.

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"It's useful for us to have a much better understanding of what a small business really is and what their tax burden really is," said Michael Linden, director for tax and budget policy at the liberal Center for American Progress. The small business is often "a term that's been thrown out by both sides to suit their needs at whatever point they need them."

Lawmakers have pointed to the complicated tax policy around small businesses--which intertwines the individual and corporate tax codes--as reason to examine both in any tax code overhaul.

The new analysis shows that small-business owners generate a slimmer amount of the country's business income than previously thought. Using a broad definition of small-business owner, the report identified 20 million small-business owners in 2007 who reported $376 billion of net business income; using a narrower method, there were 12.9 million small-business owners reporting $335 billion of net business income.

The narrower methodology defined a small-business owner as someone whose active profit or loss from the business represents 25% of their income. The broad definition was anyone who had a profit or loss from their small business.

Previously, Treasury had counted 34.7 million small-business owners with $662 billion of net business income by counting anyone who had "flow-through" income--or reported business income on their personal tax returns.

"We have had too broad a definition of small businesses," said William Beach, director of the Center for Data Analysis at the Heritage Foundation, a conservative think tank. Coming up with a more accurate definition should be used to better tailor public policy, "rather than another way to find additional revenues," he said. President Barack Obama has pushed for ending the Bush-era tax cuts on the top income brackets when they expire at the end of 2012.

Under the report's new definitions, the percentage of small-business income taxed at the top two income rates fell. Using the broad definition, 32% of net small-business income was taxed in the highest brackets; using the narrower definition, that fell to 29%. By contrast, under the previous guidelines, 50% of small-business income was taxed at the highest level.

However, the percentage of people paying taxes at the highest rates edged up under the new guidelines: about 4% of small-business owners pay the top rates, versus 3% using the old methodology.

"Conservatives will still claim that raising taxes on the top two brackets will have a disproportionate impact on small businesses and everybody else will continue to point out that's a very small number of small businesses," Linden said.

To create its new definition of a small business, Treasury officials first tested to see if significant business activity was occurring, eliminating someone reporting a small amount of income from selling items on eBay,EBAY-0.88% for instance. They also established that only businesses with income or deductions of $10 million or less qualified as small businesses, ruling out some hedge funds, for example.

Treasury staff then matched information from these small businesses with their owners' tax returns using data from a relatively new source of Internal Revenue Service data, the Compliance Data Warehouse.

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